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Reforming the Credit Rating Agencies

Credit rating agencies may not have burned down the financial system. They did, however, play a crucial role by turning a blind eye to the flames until well after they were out of control. So what will Congress do to weaken their status as the arbiters of debt? Not much. Legislation being marked up this week by the House Financial Services Committee aims to improve the quality of the ratings that the firms issue -- a good first step -- but it does nothing to remove a glaring conflict of interest or to ease laws that force investors like insurance companies and pension funds to rely on a too-small cadre of rating agencies.

Congress is looking to give the SEC more oversight of the rating agencies and require more disclosure from them. Under a current draft of the legislation, the agencies will be more open to lawsuits, but only in case of outright fraud which is often hard to prove. The SEC is already using its authority to reform the rating agencies by minimizing conflicts that arise because securities issuers pay the agencies for their ratings decisions. That's an obvious problem because it forces the agencies to please the very entities they are judging. The SEC wants the agencies to at least provide more information on who pays them, their ratings histories and data underlying the structured products they rate.

These measures should help, but real reform requires loosening their stranglehold on the market so that investors are no longer bound to rely on them.

The problems date back decades to the 1930s when the SEC began insisting that investors could only buy top rated securities. Sounds smart, but it meant that anyone buying corporate bonds and other securities had to turn to agencies approved by the SEC to make decisions about where to put their money. That, in essence, gave the private credit rating agencies the force of law. The SEC didn't help matters by refusing for years to bring new agencies into the fold. There are only 10 official ratings agencies. Two of them, Moody's and S&P, control 80% of the market.

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Over the years, despite the conflict-ridden business model, the influence of ratings agencies continued to grow. Their bad calls on complex, opaque securities would have had only an isolated effect had it not been for their dominance. Investors put their money in these supposedly high-rated instruments with the government seal of approval because of regulatory requirements. But many of the securities turned out to be worthless when the value of the homes they were based upon fell. That brought down investors from corporate credit unions to money market funds.

This summer the Obama administration actually proposed extricating credit rating agency approvals from federal rules and regulations. The task proved too difficult because the credit agencies are so firmly entrenched in the system. In a twist of irony, Treasury and the Federal Reserve required securities in many of their programs designed to revive the financial system win the highest rating from the same credit rating agencies that failed to spot the initial problems.

In the meantime, investors are taking matters into their own hands. The National Association of Insurance Commissioners says it no longer trusts the ratings system and is looking at ways to do its own due diligence. For example, it could ask insurers to pay a fee to fund a nonprofit to review the industry's investments.

That kind of skepticism and second-guessing of the rating agencies may prove to be the most powerful way to reform the industry. It’s sure to lead to more competition and diminish the dominance of the biggest rating agencies.